Tuesday, March 2, 2010

Should the Inflation Target Be Raised?

The discussion about the right structural inflation level to be targeted by central banks has resurfaced. Most notably Olivier Blanchard, head of the research department at the IMF, has proposed that inflation targets should be raised from around 2% at present to 4% in order to reduce the economic costs associated with hitting the zero nominal bound. He makes his case in a paper entitled Rethinking Macroeconomic Policy and in a shorter-version interview (see here). His main argument is that with a somewhat higher inflation rate, central banks could have slashed rates more during the financial crisis before hitting the zero lower bound.Blanchard is not alone in calling for a higher inflation target and for example Prof. Krugman supports higher inflation targets (see The case for Higher Inflation Inflation) where he adds that: "... even in the long run, it’s really, really hard to cut nominal wages. Yet when you have very low inflation, getting relative wages right would require that a significant number of workers take wage cuts. So having a somewhat higher inflation rate would lead to lower unemployment, not just temporarily, but on a sustained basis."In turn, the problems associated with the zero lower bound as well as the distortions emanating from certain prices being difficult to reduce in nominal terms (I would also add that this does not only apply to wages but also to other prices as for example it is difficult to lower rents in nominal terms unless the renters move), create costs if inflation falls too low or becomes negative.

On the other side, there are various costs emanating from higher inflation:a) Relative-price distortions: Not all prices inflate at the same rate, and so inflation generates some relative-price distortions which lead to resource misallocation. The higher the inflation rate, the greater these distortions.b) Stability of inflation expectations: It is much more difficult to have stable inflation expectations at higher levels than at lower ones. In turn, the higher the inflation rate, the larger the danger, that inflation continues to move up ever further.c) Unexpected inflation: Empirically inflation is also much more volatile at higher rates than at lower rates. In turn, unexpected inflation tends to become a significant problem, the higher the inflation target is. Unexpected inflation also leads to significant ressource misallocation.

A high level of relative price distortions as well as unexpected inflation will directly lead to ressource misallocation. Furthermore, both act to raise long-run risk premia. From a bond market perspective this means a steeper yield curve and in turn higher costs to raise long-maturity funds. From an entrepreneurial perspective it means that long-term business investment proejcts bear a higher risk (it is more difficult to forecast the business environment/cash flows) and a higher cost (again amid higher risk premia incorporated into financial markets). In turn, not only will there be a higher level of ressource misallocation but also the hurlde to carry through long-term investments is higher than in an environment of low unexpected inflation and limited relative price distortions. Both will act to weigh significantly on trend growth.

In turn, we should not be surprised to find a negative relationship between inflation and growth at higher levels. But what level exactly? The IMF itself in a research paper from 2001 (see here) found that: " The threshold level of inflation above which inflation significantly slows growth is estimated at 1–3 percent forindustrial countries and 11–12 percent for developing countries. The negative and significant relationship between inflation and growth, for inflation rates above the threshold level, is quite robust."

As a result, I fail to be convinced that a higher inflation level would provide a more favorable monetary environment for the major economies and think that it would depress trend growth rates resulting in ever increasing costs for society.

3 comments:

Quantitative/credit easing has helped to bring longer-dated government bond yields/credit yields lower than they would otherwise have been and as a result they have added to the effectiveness of easy monetary policy. In that respect they significantly lowered the cost of hitting the zero nominal bound. However, I see two problems with that:a) in a Japanese type environment government bond and credit yields in real terms will still be relatively high despite QE/CE.b) QE/CE leads to a longer and riskier central bank balance sheet. It is straightforward to rise rates but it seems much more difficult to sell the acquired assets back into the market place (alternatively, one could wait until they mature but that might be too long for inflationary pressures to remain contained).Finally, QE/CE blurs the separation between the central bank and the treasury and runs counter to the notion that a credible monetary system needs an independent central bank.I hope this helps.

While I support the idea of Japan's Finance Minister to target 1% inflation in Japan, I think that additional QE/CE could reduce govt./credit yields even with the current practice of price stability in Japan.

I don't agree that central banks need to sell acquired assets after QE/CE, as they can mop up liquidity for example by offering term deposits.

I think that danger of QE/CE weakening the independence of central banks is overestimated by market participants. So far QE/CE was very profitable for central banks. Interest rate risk can be managed by central banks as they can offer long term deposits when inflation starts to return. Credit and convexity risk is highly unlikely to cause such losses that could impair the ability of central banks to implement an independent monetary policy.

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About Me

Daniel was Head of Economics & Strategy for developed markets at Dresdner Kleinwort until early 2009 and was responsible for the well-known 'Ahead of the Curve' flagship publication. He started as a Desk Analyst in the mid-90s for the former German government bond trading desk. He then became Head of Rates Strategy early last decade and later on also took responsibility for G10 economics, commodities strategy and asset allocation.
He is now the owner of Research Ahead GmbH located in Frankfurt am Main.

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